How removing two letters could have hurt financial system

As the royal commissioner, Kenneth Hayne indicated, the “not unsuitable’’ test essentially requires the banks not to knowingly extend credit that might harm the customer. Asking about suitability, he said, invited attention as to whether there were a benefit to the borrower.

What might appear a subtle change in language could have had profound consequences.

If it turned out, with hindsight, that the customer hadn’t benefited – or worse, had experienced financial harm – it could reduce the responsibility of the borrower for their own actions and decisions and transfer at least some of that responsibility and a potential liability to the banks. It would introduce extraordinary moral hazard into the financial system.

There was discussion of the concepts of ‘’caveat emptor’’ (buyer beware) and ‘’caveat venditor’’ (vendor beware) while the commission process was occurring, with warnings of the importance of ensuring that consumer retain primary responsibility and liability for their own decisions and actions.

In the final report Hayne, thankfully, said he was not persuaded the test should be changed.

There were a couple of developments last year that may have helped him come to the conclusion that there wasn’t the need for radical change to the law for the banks to meet the responsible lending requirements.

There was heavy criticism of the banks within the commission hearings for using statistical benchmarks, the Household Expenditure Measure (HEM) in particular, and/or their own estimates to calculate borrowers’ expenditures rather than their actual spending.

Hayne remains unconvinced their approach constituted the level of inquiry and verification the legislation required.

By the time he wrote his final report, however, a lot had changed.

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The banks themselves have moved quickly to develop more rigorous processes for verifying borrowers’ incomes and expenditures, a reaction to the commission and their own regulators’ actions that is being blamed for significantly lengthening the approval process and generating a credit squeeze.

Of perhaps greater import for the royal commission, however, was a judgement in the Federal Court.

The Australian Securities and Investment Commission had extracted the largest-ever fine ($35 million) from Westpac for alleged breaches of the consumer credit protection laws that centred on the bank’s use of the HEM.

When the parties asked the court to ratify the agreement, however, Justice Perram refused, saying he wouldn’t declare conduct that was not unlawful to be unlawful and that there was nothing in the settlement to say how Westpac’s reliance on the HEM was a breach of the responsible lending laws.

Hayne referenced the case in his final report and the fact that ASIC and Westpac are still trying to determine how to proceed. There could yet be a trial.

He did say, however, that if the court processes revealed some deficiency in the law’s requirement to make reasonable inquiries…